Small-cap stocks enjoy best first half since 1991 as AI trade expands

Small-cap U.S. stocks are coming off one of their strongest first halves in decades. But this is not your ordinary small-cap boom led by traditional businesses linked to the economic cycle.

The work, like its larger capitalized counterparts, was driven by the rapid development of AI infrastructure as spending spread beyond the largest tech companies to a broader network of suppliers.

Investors believe the rise in small stocks can continue and extend beyond technology as long as interest rates remain under control.

Russell 2000 The index is up more than 21% this year, putting the gauge on track for its best first-half performance since 1991. This advance marks a sharp turnaround after years of underperformance against large-cap peers.

“This is both a valuation catch-up story and a fundamental story,” said Amy Zhang, Alger portfolio manager. “The valuation gap was so wide that a truck could drive through it. At the same time, fundamentals are improving by small amounts, and I think that’s causing the trade to expand.”

Semiconductor and semiconductor equipment companies were the biggest winners, underscoring how the AI ​​investment boom is spreading into the broader market. Chip-related companies make up 16 of the Russell 2000’s 50 best-performing stocks this year. Aehr Test Systems, Ichor Holdings And MaxLinearAll of these rallied more than 400%.

Rather than competing directly with industry leaders like Nvidia, many of these smaller companies are taking advantage of growing demand in the AI ​​supply chain. As chipmakers and cloud providers increase spending on AI infrastructure, suppliers of semiconductor equipment, components, and connectivity solutions are seeing earnings trickle down and companies with much smaller market capitalizations are driving revenue and earnings growth.

“I think a significant part of the small-cap story depends on AI,” Zhang said. “The impact of AI investment is trickling down from large-cap leaders to small-cap companies. The impact will be greater for small-cap companies in terms of revenue and prospect growth.”

More than Artificial Intelligence

While AI is a key driver of the rally, strategists say the small-cap recovery is supported by a broader set of fundamental headwinds and could continue.

“Despite small-caps gaining meaningful exposure to semiconductors and tech hardware, small-caps’ leadership is notable in a mega-cap-driven bull market,” said Adam Turnquist, chief technical strategist at LPL Financial. “Building underlying strength also helped offset headwinds from higher rates.”

Consensus estimates for 2026 earnings growth for Russell 2000 companies have risen to 38% from about 23% at the start of the year, according to LPL; This reflects growing optimism that profit growth is extending beyond the largest tech companies.

Turnquist also noted several other catalysts that could continue to support the asset class, including greater exposure of smaller companies to the U.S. economy, expectations for increased merger and acquisition activity, especially in the pharmaceutical and biotechnology industries, and tax incentives designed to encourage capital investment.

Are higher rates a threat?

The biggest threat to the small-cap rally may be the same force that has held the group back for years: higher interest rates.

The Fed’s next meeting will take place July 28-29, with traders pricing the likelihood of a rate hike at around 30%, according to CME Group’s FedWatch tool. As of September, markets see the probability of an increase of at least a quarter point at over 60%.

Higher borrowing costs pose a particular challenge for smaller companies, which often carry more variable-rate debt and face greater refinancing needs than their large-capitalization counterparts. Bank of America estimates that each additional 25 basis point increase would reduce Russell 2000 operating profit by about 2%.

“This could challenge the expected Q4 earnings momentum (and sentiment) in small caps, which have the most refi exposure,” Bank of America strategists said in a note. he said.

Despite this, many investors believe the worst of the tightening cycle is over. The Fed raised interest rates by a cumulative 500 basis points between March 2022 and mid-2023; this became one of the most aggressive march campaigns in decades.

“We’re probably near the peak of inflation and rates,” Zhang said. “We’ve had significant headwinds over the last five years, and I think that will abate and become a tailwind.”

—Reporting by Deena Zaidi